How Tax Evasion Works

The tools of business and corporate tax evasion are much the same as individual tax payers: underreporting of income, overstating deductions, claiming too many tax credits, and hiding money from the government through laundering or illegal accounting schemes. When we hear the words "corporate tax evasion," we immediately think of the headline-grabbing corporate scandals of the past decade, like Enron or Tyco. But the surprising fact is that the vast majority of business-related tax evasion is committed by smaller unincorporated businesses.

As we mentioned earlier, individuals who own a small business are the largest single contributor to the tax gap. Underreporting of business income accounts for $122 billion, or 27.1 percent of the total $450 billion tax gap [source: Internal Revenue Service]. But even that number might be low, considering that many small business owners are considered self-employed for tax purposes. According to the IRS, self-employed taxpayers underreported $57 billion of income. When you add that to underreported business income, you have 40 percent of the tax gap tied to small business owners and self-employed sole proprietors [source: Internal Revenue Service].

Corporations file a different tax return than individuals and corporate income is taxed at a different rate than regular income. Even though corporate misdeeds grab a lot of press, corporate underreporting accounts for only $67 billion of the tax gap, or 14.8 percent. Of that underreported corporate income, 71 percent is committed by corporations with assets greater than $10 million [source: Internal Revenue Service].

Employment taxes are another area that's rife with tax evasion. Employment taxes are taxes that employers pay for each of their employees. These include unemployment tax and payroll taxes. Payroll taxes are the matching contributions that employers make to the Social Security and Medicare trust funds. Employment taxes are a significant expense, so it's not surprising that employers evaded $15 billion in employment taxes in 2006 [source: Internal Revenue Service]. Paying in cash is one of the easiest ways to avoid employment taxes. Some tax evaders employ a scheme called pyramiding, in which an employer or a payroll contracting company withholds Social Security and Medicare taxes from employees, but never deposits them with the IRS [source: Internal Revenue Service].

Now we'll look at how the IRS catches tax evaders and what the penalties are for this costly crime.

Nanny Taxes

If you pay any individual more than $1,800 in cash for working in or around your home, then you need to withhold and pay payroll taxes (Social Security and Medicare). If you pay more than $1,000 per quarter to a household employee, you also have to pay federal unemployment tax [source: Internal Revenue Service]. If you don't, you're not alone. Eighty to 90 percent of people who employ babysitters, housekeepers and home health aides fail to pay these so-called "nanny taxes," including several high-profile political appointees in recent years [source: Lieber].